Low valuation in biotech can be like quicksand under a mirage of low-hanging fruit. That’s because the market is inhabited by growth investors who think cheap stocks are cheap for a reason. Zacks Investment Research Senior Biotechnology Analyst Jason Napodano operates with this in mind as he evaluates biotech companies. He also understands that while value can be a good friend, an investor’s best buddy is momentum powered by vital market-moving events. Napodano shares his best stock ideas in this Life Sciences Report interview.

The Life Sciences Report: Jason, you do very detailed research on micro- and small-cap stocks that, almost by definition, don’t get a lot of attention from the investment community. This realm is something like a halfway house, where stocks could drift into obscurity and never be heard from again or miraculously arise on news, deal-making and data. I wonder how an analyst justifies the time spent on research in this space, when the odds are so stacked against success?

Jason Napodano: Many of the names that we focus on at Zacks?and a lot of the names that I specifically cover?have drifted down to the obscurity level. But our mission is to follow underfollowed or undervalued stocks that have catalysts in their future. Oftentimes these stories have received limited investor attention because they became public without a lot of fanfare, or via reverse merger, or perhaps they had one big drug failure and the market wrote them off. I look for small- and micro-cap stocks that have drifted down, and I ask what could bring these guys back.

How do I justify the time spent? These stocks often have one or maybe two drugs that drive them. It may take a couple of weeks?or even a couple of months?to do the work on one lead drug in a clinical trial, or on a drug that is waiting on a U.S. Food and Drug Administration (FDA) decision. Once the work is done, there’s not a whole lot to update because the focus is on that one drug. We cover many more stocks than analysts that follow the big caps. That’s how we can justify spending time on some of these names.

TLSR: What do you look for in a stock?

JN: One of the things we look for, specifically in small caps and specifically in biotech, are catalysts. Valuation alone is never a reason to buy a stock. I’ve found that cheap stocks tend to get cheaper. Expensive stocks tend to get more expensive. So the buy-low, sell-high phenomenon doesn’t necessarily work in biotech. Most of the time it’s buy high and sell higher. . .and try not to catch falling knives.

It all goes back to catalysts. You have to have a reason for a share price change. If a company is in obscurity or is being ignored by Wall Street, what changes that? Not valuation alone. There has to be something coming up that I, as an analyst, can hang my hat on. I want to be able to say, “Here’s a name that most people are not paying attention to, but in six months this event will occur.” It could be a release of new data, an upcoming FDA decision, or we may think the company is going to get a partnership.

Meanwhile, biotech companies burn cash. A biotech company that doesn’t have catalysts and is burning cash is a recipe for a bad investment. Does a company have a catalyst before it runs out of money, or before it needs to go out and raise new capital? Investors have to take all these things into consideration.

TLSR: As you say, cash burn can be a special problem in biotechs, and dilution is a problem we always talk about in these small stocks. How do you deal with cash burn that results in dilution?

JN: One of the things I consider is whether a company can self-fund. Can it get to where it needs to be, and can it run its business model without the need to go back to the capital market repeatedly? I point investors to names like Pozen Inc. (POZN:NASDAQ) or Depomed Inc. (DEPO:NASDAQ), which have innovative technologies and have been able to bring molecules not necessarily to the goal line of commercialization, but close enough to attract interest from larger pharmaceutical companies and partnerships. That puts these companies in position to attract nondilutive cash through up-front payments, licensing deals and the like.

Depomed does an excellent job of out-licensing its drug delivery technology, Acuform, which creates an extended-release formulation of generic molecules, and it has excellent patent protection. It turned this technology into an ATM machine, which has allowed it to push its pipeline forward without having to go back to the market constantly to raise cash.

Another example is Pozen, which has developed several drugs and entered into pharmaceutical partnerships with GlaxoSmithKline (GSK:NYSE) and recently Johnson & Johnson (JNJ:NYSE). These blue-chip partnerships provide the company with nondilutive cash that allows it to continue to develop drugs without constantly having to go back to the capital markets, sell new shares, give warrants and the like, which biotech investors don’t like to see.

TLSR: We see micro-cap companies, or even small-cap companies, struggle to get through phase 2a clinical trials to get a big pharma or biopharma to make deals with them. If pharma is not interested in a molecule or technology platform, can you assume that it’s going to be a dud?

JN: I don’t think so. Pharma tends to be very risk-averse, and it also tends to focus on what it can get to the market in the next two to three years. It wants to see a return sooner rather than later. That doesn’t necessarily mean the drug is a dud. The drugs that pharmas were passing up in phase 1 and 2 in 2008 and 2009 are the drugs that they are now looking to partner on in 2012 and 2013.

TLSR: You have spoken at length about how important it is to have catalysts in stocks you intend to cover. At least one company in your coverage that I’m aware of came to the public market without a clinical asset. Would that model work in the current environment?

JN: Probably not. Not unless the company had a new, revolutionary platform that big pharma was dying to get ahold of. Big pharma was interested in RNA interference (RNAi) platforms a couple of years ago, but stem cells never seemed to attract the big pharma partners that investors thought they would attract. In fact, big pharma still shies away from new technology platforms like stem cells, gene therapy and others. If you’re a biotech company today, and you don’t have any clinical stage assets, you will probably struggle to get a partnership?or even to secure enough capital to bring a new molecule to the market. Big pharmas are still pretty stuck on small molecules, and they are only slowly making their way into monoclonal antibodies.

To the point of having catalysts, when small companies get in front of investors, they really need to map out the next 6?18 months like a staircase, with milestones they can hit to create new inflection points. However, taking a molecule from preclinical to phase 1 and through a single ascending dose safety study is not exciting enough for investors. A company doing this is likely to be ignored.

TLSR: Jason, you have a couple of companies under coverage that are doing development from the ground up. Neuralstem Inc. (CUR:NYSE.MKT) is one of these. It has a dual platform of stem cells and small molecules that tie in together. Can we start with Neuralstem?

JN: Neuralstem is very interesting because it is trying to do something that’s never been done before. That is what attracted me to the stock. It’s still early stage compared to most of what we go after at Zacks. It has two phase 1 assets, which tend to be too early in development for investors, but the company was worth digging into and initiating coverage on. Neuralstem is taking human neuronal stem cells and injecting them directly into the spinal cord to improve outcomes in patients with amyotrophic lateral sclerosis (ALS), a highly debilitating and always fatal disease for which there is no cure.

The phase 1 study is, of course, primarily about safety, but the data generated so far represents a pretty big milestone because no one has ever done this kind of work before. Just the fact that the company has developed a device and system to perform that procedure safely creates a platform for additional applications in the future, potentially in multiple sclerosis (MS) and spinal cord injury. We know it is still very early stage, but it is interesting. If Neuralstem can develop a therapy for ALS, it would be sitting on a blockbuster.

TLSR: Back on June 16, the company treated its 16th patient with stem cell injections in both the cervical and the lumbar region. This was the first patient ever to receive stem cells in two locations. Although this study is about safety, are we learning anything about efficacy?

JN: Because this study is powered as a safety analysis one must be hesitant about making hard efficacy conclusions. But there are some measures. ALS is a highly degenerative disease. Patients rarely, if ever, spontaneously stabilize or improve, but there have been signs that some patients have stabilized or even improved in this phase 1 study. That alone is encouraging and warrants further analysis. The goal now is to establish safety, and then go into a phase 2 study and start to establish proof of concept.

I would mention that Neuralstem has tested both ambulatory and nonambulatory patients. The company says patients need to have some living spinal cord tissue to see improvement. So some patients’ diseases may be too advanced for neural stem cell therapy to work. That’s the kind of thing you parse out in phase 1 studies.

TLSR: Back in early September, news that Neuralstem had licensed out its spinal cord delivery platform and floating cannula (SCDP-FC) system for cell implantation, which you referenced, pushed the stock upward. Although the company has now dosed 18 patients with cells, why did the stock react so favorably not on patients receiving cells, but rather on licensure of that system?

JN: Let me go back to what I said about companies finding a way to self-fund. I referenced Depomed, which has an extended-release technology called Acuform that it licenses to big pharma companies. The technology has turned into an ATM for Depomed. Neuralstem has created a way to safely inject drugs or cells directly into the spinal cord with its floating cannula. Potentially, this could turn into an ATM for the company.

TLSR: Neuralstem has about $35 million ($35M) left in a shelf registration right now, but I understand that it does have enough cash to operate into Q4/13. Is it your feeling that the company will have partnered by that time?

JN: Beyond its revolutionary stem cell technology and platform for ALS or spinal cord injury, Neuralstem also has a traditional small molecule platform, and is testing a drug specifically for major depressive disorder (MDD). It is designed to reduce hippocampal atrophy, which is a new hypothetical cause for diseases like Alzheimer’s and MDD. The drug, NSI-189 phosphate, is in phase 1b, and I believe data are expected shortly?probably in the first quarter of 2013.

To your question, I think the company’s goal is to partner its small molecule platform after this data is released. The cash from this deal should allow management to put off having to partner the stem cell platform until after phase 2 proof-of-concept data has been generated. This will create significantly more value for investors.

TLSR: What are the next catalysts for Neuralstem? The reason I’m asking is that this stock is up 143% over the past 12 weeks. It would be nice to know whether it has more upside or if investors are ready to take profits on the next catalyst.

JN: Neuralstem will present additional safety data from the ALS trial at the Motor Neurone Disease Association conference on Dec. 6. Data on NSI-189 is expected in Q1/13. Management’s goal is to partner after the NSI-189 data come out. You have three potential catalysts over the next two to three months. I don’t know how much the additional safety data on the ALS program is going to move the stock, but preliminary signs of efficacy seen so far in the phase 1 trial certainly warrant attention.

TLSR: How about another company?

JN:Acadia Pharmaceuticals Inc. (ACAD:NASDAQ) is an interesting name. It was up dramatically?almost 150%?on Nov. 27 when data were reported and Acadia hit what I would call a home run. Just a bit of background: The company actually had two clinical-stage assets at one point, one of which failed a few years ago, after which the stock got hit pretty hard. The other one, pimavanserin, also failed a phase 3 trial a few years ago, and the market wrote this company off. Many sellside analysts dropped coverage, and it got down to a point where only I, and maybe one or two other analysts, were even talking about it.

We initiated coverage at Zacks and told investors that a huge potential catalyst would be coming on a second attempt at a phase 3 trial with pimavanserin for Parkinson’s disease psychosis. We looked at the original trial design to understand why it failed the first time, and we’ve been trying to educate investors as to why we believe this trial might succeed. It’s been a long process. The trial has been going on for almost two years. Pimavanserin is now a phase 3 asset with clear proof of concept, efficacy and safety demonstrated. Acadia needs to do one more phase 3 trial, and then it can file for approval. This is the kind of success that big pharma is interested in right now.

TLSR: Considering this big move up, which seems to be holding steady, what are the next potential catalysts for Acadia?

JN: There are not a lot of derisked phase 3 central nervous system (CNS) assets out there. This is a CNS asset that just popped up on every business development manager’s desk in big pharma. I think investors need to take a look at Acadia, especially if the stock pulls back from its highs.

TLSR: Another company?

JN:Trius Therapeutics Inc. (TSRX:NASDAQ) is another company with a phase 3 asset?an antibiotic?that looks to compete with Pfizer Inc.’s (PFE:NYSE) Zyvox (linezolid), a $1.5 billion ($1.5B) revenue drug. Trius is developing an improved, next-generation version of the drug called tedizolid. It has generated positive data in one phase 3 trial already. The second phase 3 trial is similar to the first, except that the patients will start on an injectable formulation of the drug and then transition to oral. Oral antibiotics tend to be prescribed for outpatients; if a patient is in the hospital she will tend to get an injection. The FDA wants to see whether there are any differences between the injection and the oral dose, but I don’t see a big risk here. The company has done bioequivalence and bioavailability studies to show that the dose in transition is the same for its molecule. Based on the improved characteristics of the drug versus Pfizer’s drug, this could potentially be a $500M or maybe even $750M product. At about $5/share today, we think Trius is pretty attractive based on that market opportunity.

TLSR: Jason, Trius is trading at about a $200M market cap currently, which is rather small relative to the peak potential sales you mention. Do you have any idea why this stock has been weak?

JN: Biotech had a pretty good Q3/12, but the last month or two have been rough. It’s always hard for me to say why a good stock has been weak. The company has cash. It has proof of concept and proof of efficacy, as demonstrated in the first phase 3 trial. The only thing that I can think of is that its drug is going up against a Pfizer drug, which is already established in this market. Tedizolid will also compete with Cubist Pharmaceuticals Inc.’s (CBST:NASDAQ) drug Cubicin (daptomycin), which has close to $1B in revenue.

TLSR: Another one, please?

JN: The next 30 days could be very interesting for Titan Pharmaceuticals Inc. (TTNP:OTC). Its subdermal, slow-release formulation, Probuphine (buprenorphine), is for opioid addiction. The treatment is injected under the skin and the drug is released for six months. The drug on the market now for the same indication is called Suboxone (buprenorphine + naloxone, manufactured by Reckitt Benckiser Pharmaceuticals Inc. (RBGPY:OTCPK)). Suboxone is available as a sublingual tablet or a film. Compliance can be a problem in a population of heroin-addicted patients, and an implant could be a huge asset in helping improve compliance and outcomes.

The company says it has an undisclosed pharmaceutical company interested in commercializing the drug. This particular company has made an equity investment, and so Titan has cash to negotiate the best deal for investors. The company is continuing its due diligence and expects to make a decision on whether or not to acquire the drug by the end of December. I think this drug represents a $300M opportunity, and if you look at Titan’s current market cap of about $70M, you can see that its share price will be closely tied to the success of this product. I think Titan presents investors with some upside over the next month or so. Signing a partnership and then getting a new drug application (NDA) accepted by the FDA for priority review are two things that should drive the stock higher. All this will happen in December.

TLSR: I know you want to mention Pozen and Depomed, since you’ve already talked about them and indicated that you liked them. Go ahead.

JN: I’ll talk about them together because they both are companies that have done a very good job of self-funding and of bringing products to the market without diluting shareholders.

Pozen is getting ready to file for approval of its safer aspirin product, PA32540. The drug combines aspirin and a proton pump inhibitor (PPI) (omeprazole, branded Prilosec), into one pill. Daily aspirin therapy is a staple for many Americans for secondary prevention of cardiovascular disease, and the cardiovascular benefits of aspirin have been well documented. Unfortunately, the gastrointestinal (GI) toxicity of aspirin is also well documented, especially in those patients at risk for aspirin-related stomach ulcers. Again, this is a compliance issue. If patients would take aspirin and a PPI at the same time?all the time?they would get the cardiovascular benefits of aspirin without any of the GI toxicity. But compliance is low because patients must remember to take the two pills. The combination in a single pill makes it much easier.

It’s not a home-run indication, but it’s a simple concept, and it should see FDA approval in the first half of 2014. Pozen is looking for a marketing partner now, and we think a deal may be coming after the NDA filing in the second quarter 2013. Pozen has plenty of cash, so there is low risk on the financing front. We also see low risk on the regulatory front as well. I think this stock is a good, safe investment.

TLSR: Pozen has a $160M market cap, with $92M on the balance sheet. What is it going to do with all that cash?

JN: That is interesting?and there is potentially more cash coming when it partners its drug. Who knows what it is going to do with all that cash. Maybe a bid distribution to shareholders? Wouldn’t that be a refreshing turn of events!

TLSR: Go ahead with Depomed.

JN: Depomed, again, has a good amount of cash. It has done an outstanding job in turning its technology into an ATM. It is commercializing two drugs right now, and it collects a royalty on another drug. Gralise is an extended release gabapentin product developed for postherpetic neuralgia (PHN). It competes with generic gabapentin and branded Lyrica (pregabalin, marketed by Pfizer), which makes this a tough, competitive market. But it is also a pretty large market. The indications for gabapentin are numerous.

TLSR: Depomed also has Serada under FDA review for hot flashes.

JN: It is the same formulation as Gralise?an extended-release formulation of gabapentin. The company changed the name of the drug so as not to create confusion at the pharmacy or at the doctor’s office.

TLSR: This has been wonderful. Thank you for all the information.

JN: Absolutely. This has been great. Thank you.

Jason Napodano currently works for Zacks Investment Research as the company’s senior biotechnology analyst. In 2009, Napodano was promoted to managing director of research for Zacks’ Small-Cap Research division, which focuses on writing high-quality institutional research on underfollowed or undervalued small-cap stocks. Prior to his tenure at Zacks, Napodano spent three years on the buyside with Eastover Capital in Charlotte, N.C., where he focused on large-cap equities and specialized in healthcare, energy, and technology. Prior to joining Eastover, Napodano worked as a research scientist for TechLab Inc., a biotechnology company focused on developing diagnostic kits and vaccines for infectious diseases. He also spent a year working in a lab at the Fralin Biotechnology Center, and a year working for a cancer researcher in Virginia.

Napodano has a bachelor’s degree in biochemistry from Virginia Tech, with an additional bachelor’s degree in chemistry and a minor in math. He has a master’s degree in business administration and finance, with a concentration in securities analysis, from Wake Forest University. Napodano is also a Chartered Financial Analyst (CFA).

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DISCLOSURE:
1) George S. Mack of The Life Sciences Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Life Sciences Report: Neuralstem Inc. Johnson & Johnson is not affiliated with Streetwise Reports. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Jason Napodano: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.

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